GDT 193 interesting

At the time of the last auction I identified that it was hard to get excited with either the price action or the prospects for the auction (#192) given that +/- 1% looked to be likely (and indeed the outcome conformed to these expectations).

However, this week’s auction falls into a very different category. Price action has been interesting, industry developments – not the least of which is Fonterra raising FGMP guidance both in New Zealand and Australia – have been somewhat optimistic and intriguing and activity in the broader dairy commodity complex has been interesting. While price action has has not been uniformly strong across the complex, I get the sense that something is building.

Rice Dairy commentaries are suggesting greater levels of activity from Mexico, trade data is suggesting increased buying out of China and some companies that are operating closer to the end buyer (Fonterra and Friesland Campina) are exhibiting greater stronger signs of confidence than you would derive from just observing the commodity end of the market – so let’s hope that they are astute and correct!

As noted above, Fonterra surprised the market somewhat this week with a revised FGMP forecast of $6.75/kgMS. I made the point in my last commentary that the MyFarm model was producing an indicative price of $6.90/kgMS so $6.75/kgMS (in my view) is not in any way misleading. However, given how early we are in the season it does reflect a degree of confidence from Fonterra that is mildly surprising.

The auction this week looks like a positive result with WMP futures suggesting a +3% - +5% move while some other products and increased volumes on offer may moderate that. The action has been in the front part of the curve and WMP curve is flat (to slight backwardation) into 2018.

Running the MyFarm model again for price action in the last 2 weeks provides a price based on forward curves and our FX assumptions of $7.01/kgMS or a 26c premium to Fonterra’s guidance compared with a 40c premium that we were observing 2 weeks ago.

Charts:

I thought that it was worthwhile summarising some of the above commentary in charts. The first is simply the NZX 2017/18 FGMP contract. It shows that while action was around the $6.50/kgMS level pre and post auction #192, some bidding interest emerged at $6.55/kgMS earlier last week before moving to $6.70/kgMS post Fonterra’s announcement. This contract is now trading at an all-time high. 

The second chart compares price action in the NZX WMP commodity future versus NZX SMP. It shows clearly the divergent price action in recent months with the European market overhang impacting SMP.

 

I also made reference to China activity. The latest China trade data released last week (chart courtesy of Rice Dairy) shows increased activity across the board but very clearly in the WMP, infant formula and cheese categories.

What is potentially very impactful, however, will be China’s activity through the second half of this calendar year. In the table from Rice Dairy below, for WMP imports you can clearly observe that Chinese activity was relatively muted in the 2nd half of each calendar year (circa 20,000 tonnes per month on average). If we could see less seasonality and steadier imports across the year from China, the impact on the market could be considerable. This is one thing I will be watching for, particularly through the months of September and October where Chinese interest has traditionally moderated significantly. While the seasonality is clear and pronounced, we don’t have a clear view on stocks and if inventories are below normal we may see some divergence from past experience here. Rabo Bank recently pointed to this lower inventory position – one that may now be exacerbated with severe droughts being experienced in north and north eastern China.

My final chart in this section is the NZD / USD exchange rate. With USD weakness dominating markets, we have seen the NZD rally sharply to US75c and the AUD rally sharply to US80c. While unwelcome to exporters, the move has yet to materially impact current season receipts. In its Farmgate Milk Price Statement published in September 2016, Fonterra noted that as of the end of July 2016, it had hedged approximately 70% of the seasons USD requirements. Presuming that there has been no change in policy, we would expect that about 70% of the current season’s requirements are hedged at this point. The chart below uses an 18 month moving average as a proxy for the Fonterra hedging policy (which is significantly more sophisticated in use of instruments and execution). This shows the difference in effective rate a hedging policy could deliver policy versus using the current spot price.

Corporate Activity:

The chart below provides a visual of the share prices performances (indexed) of some of Australasia’s dairy companies. A2M was again a beneficiary this week of revised earnings and continued infant formula demand from China. There has been some muted flow through to SML. Fonterra benefited a little from the earnings reaffirmation contained as part of the FGMP update but the share price has literally “flat lined”  over the last 12 months.

By contrast, MGC and Bellamy’s continue to struggle in the Australian market.

MGC last week announced its milk intake for 2017/18 will be an estimated 2.3 blln litres, down from 2.7 blln litres in 2016/17 (3.5 blln litres in 2015/16). This 34% fall (1 blln litres) in Murray Goulburn’s milk intake in 2 seasons must be incredibly challenging for management and follows an initial opening price from MG for this season ($4.70/kgMS) well below those indicated by Fonterra, WCB and Bega ($5.30-$5.70/kgMS). MG responded by lifting its indicated minimum price to $5.20/kgMS but with Fonterra Australia upgrading its minimum forecast payments to Australian suppliers again last week from $5.30/kgMS to $5.50/kgMS, this loss of suppliers is unlikely to be over. One article in the media over the weekend suggested that 242 Victorian dairy farmers (circa 5%) have in fact hung up their gumboots in the last 12 months!

MG also highlighted the challenge of the stronger AUD to them achieving higher than currently forecast payout in the current season.  This perhaps points to an FX hedging policy somewhat different to that of Fonterra (see above).

Bellamy’s emerged from its trading halt with little clarity on the state on the CNCA license for the Braeside plant but the market appears willing to give them time.

However, it is also worth noting that it is not just the dairy sector that is feeling the impact of Chinese regulators. Last week, China banned beef imports from 6 Australian abattoirs (5 companies). The concerns were reported to be related to “labelling” (an issue that impacted Parmalat a few weeks ago). The meatworks impacted included Kilcoy (owned by the large Chinese corporate New Hope Group), 2 JBS abattoirs in NSW and Queensland, a Thomas Foods plant in South Australia and 2 other plants owned by Australian Country Choice and Northern Meat Co-op respectively.

There were similar issues in May (some of the same abattoirs) with respect to lamb exports. My understanding is that these were resolved within 45 days and related (reportedly) to labels coming off boxes.

Bottom line, is that China regulatory issues are becoming more common. Food safety compliance is critical and a ban is a ban no matter how minor the infraction. It appears that getting clarity from the authorities on details of the reported infraction is the critical issue, particularly for publicly traded companies.

Just for interest:

Regular readers will know that I often like to include a couple of charts that just take my fancy.

The first below came from a Citigroup commodity report and compares the GSCI (an S&P commodity index originally formulated by Goldman Sachs) to the S&P500 (US equity) index. This chart could be interpreted 2 ways (ie. equities are very expensive or the commodity complex is very cheap – or indeed some combination of the 2) but nevertheless is somewhat interesting!!

This second chart / table comes from a recent USDA report although the data is some 4 years old. We are all aware that India is both the biggest milk producer and has the largest herd of cows (and buffalo) but it is, nevertheless, interesting to see the numbers. While NZ sneaks into the top 10 of milk producers, with 5 million cows (2015/16) we fail to make the top 10 in herd size and Australia – at a reported 1.66m cows in the dairy herd – is well off the pace (a bit like their rugby)!

Summary:

As noted, there is enough activity to suggest that this week’s auction will be somewhat more interesting than those through June and July. Confidence amongst some of the larger global dairy companies is up and farmer confidence (at least in NZ) will be rising along with projected payout. At $6.75/kgMS payout and a 45-55c “available for payment” (call it 40c cash), Fonterra suppliers are looking at income of above $7/kgMS on current projections.

Similarly, Fonterra Australia has increased its indicative price to $5.50/kgMS and is indicating a closing price could reach $5.80/kgMS. With existing Fonterra suppliers also being repaid 40c for the 2015/16 season (related to the clawback), some Australian farmers are looking again at cash of > $6.00/kgMS.

Of itself, these projections would suggest increased supply but it is too early to make calls on that front. Parts of NZ have had record rainfall (and it has been cold) while Victoria has been cold but relatively dry. Spring is just 4 weeks away!